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Some major U.S. banks have used bogus regulated investment corporations — which turned loan interest into tax-free dividend payments — to shield nearly a billion dollars from state tax collectors, The Wall Street Journal reported on August 7.

This latest shelter scheme exploits state laws that allow tax-exempt or even tax-preferred transfers between corporate parents and their publicly traded spin-offs, even though the only fund “customers” appear to have been the banks themselves. The 11 funds in question have been dissolved since May.

Securities and Exchange Commission filings dating back to 1999 reveal that at least 10 major banks funneled over $17 billion through the suspect investment vehicles after getting the go-ahead from KPMG. The accounting firm continues to battle with the IRS over its shelter registration and list maintenance practices and has been linked to various high profile promoter schemes.

Comment on underlying strategy

The basic concept on offer was (and is) sound. The idea: the government taxes a dollar of (let’s say) interest differently than it taxes a dollar of (let’s say) dividends. So run your money through a transmogrifying machine, and convert interest to dividends. Why not take advantage of the way the law is written?

Yet the deal blew up in the face of these really smart bankers. Why?

Why tax shelters fail — hog theory

Pigs get fat. Hogs get slaughtered.

Why tax shelters fail — bought from known promoters

Not so obvious is why you shouldn’t buy a tax shelter from a promoter (and I use that word “promoter” in the most loving way possible).

KPMG appears to be notoriously aggressive and also appears to be on the hit parade of the tax authorities.

The IRS (and now the California tax authorities) are hard on the trail of tax shelters. They look at known promoters, subpoena their records and do the fandango on the heads of the promoters and their clients. KPMG is a known promoter.

Moral of the story: don’t do business with people with shady reputations. Unfortunately, KPMG is in that position right now. Stunning for such a high-flying organization with a previously stellar reputation.

Tax shelters fails when bought from known promoters because tax shelters rely on non-discovery for their success. Buying from a known (to the IRS) tax shelter promoter is a guaranteed ticket to an audit.

Why tax shelters fail — discovery is statistically guaranteed

There’s a second reason why tax shelters like this fail. I read a paper by law school professor Mark Gergen, entitled Dynamics of Marketing of Shady Tax Strategies. Look at Part III, starting on page 20. The blunt truth about tax shelters is that even with efforts to conceal them, the IRS will find out. Statistically it is inevitable.

Let’s say a promoter offers you a tax shelter. You’re going to tell your spouse. Even if the promoter swears you to secrecy, you’re probably going to tell someone over cocktails that you’re looking at this fabulous thing. You’re going to give it to your lawyer or accountant for review. They’re probably going to say a word or two to someone. Then you decide not to do the deal. Well. Five or six people know about the deal and you didn’t buy it.

Now think of how many times the promoter puts the deal on the table to other people. Do the math. All of a sudden there are perhaps 100 – 200 people who know about this deal EVEN THOUGH NO ONE HAS BOUGHT IT YET.

Promoters will tell you that they will only sell it a limited number of times. (E.g., I saw a proposed tax shelter from an unnamed Big 4 accounting firm that said they’d only sell it to 12 customers). But that’s not the problem. The problem is in the sales process for a tax shelter deal. It is in peddling this thing around town that the word gets out.

How many prospects does a promoter have to pitch a deal to until he gets 12 buyers?

Now apply the “six degrees of separation” principle to this situation. Ask yourself how soon it will be until someone knows someone who works at the Wall Street Journal (see example above) or Forbes or (God forbid) the IRS.

Bottom line: inevitably these tax shelters must be discovered. They rely on non-discovery for their success. This is an illusory goal.

Why tax shelters fail — we’re smarter than the IRS

Non-discovery is one key strategy for a tax shelter: “If the IRS doesn’t find you, the tax shelter is guaranteed to win.” (Lying works the same way, buddy, and it’s cheaper. Why not lie on your tax return?)

The other way that tax shelters fail is in their monstrous complexity. Complexity arises from the confluence of two vast streams of effluent.

Complexity is born from the enormous pneumatic egos of the tax shelter architects (“I’m smarter than anyone at the IRS”).

Complexity is born from necessity: tax shelter theory flies in the face of reality and common sense. You have to be a medieval theologian to believe in them. If you can count angels dancing on the head of a pin, you’ll be a great tax shelter promoter.

Complexity means too many possible points of failure. When there are many intricate steps from here to tax nirvana, it is too easy to fail in the plan (oops, forgot a step) or in the execution (oops, skipped a step).

Complexity means there are too many points of disclosure. When there are many components to a plan, that means there will be more paperwork and disclosure to the IRS. That means more little flags waving, saying “Audit me!”

Complexity means that no one really understands the deal. So you, dear client, are going to put your tax-paying butt on the line — and a big chunk of your net worth, too — on a deal you don’t understand. That, ummm, lacks brilliance.

Happy Friday. Some day I’ll tell you how to do tax shelter right. Or not.